Monday, September 8, 2014

6 big mistakes you can make benchmarking to the S&P 500

by J.J. Zhang's

“Compared with the S&P 500 market returns” is one of the most commonly used terms in the personal finance world. You see it everywhere comparing how this stock, this ETF, this hedge fund, or how your portfolio stacks up versus the S&P 500.

As an engineer, I have a deep appreciation for benchmarks and metrics and there’s no denying that it’s an important comparison to make. However, there are a number of flaws with the way many use this benchmark that unfortunately can skew their impression of returns. Here are six of the most common mistakes:

1. Ignoring friction

The exact S&P 500 index benchmark return is impossible to achieve. The S&P 500 index is a purely theoretical product. It’s a frictionless construct which ignores trading fees, bid-ask spreads, liquidity, and all sorts of other factors. The two leading S&P 500 ETFs, SPDR’s SPY, -0.12%   and Vanguard’s VOO, +0.48%  , have expense ratios of 0.09% and 0.05% which represent real costs investors have to pay to get S&P 500 performance.

Because of these expenses, they’ll always perform slightly worse than the S&P return. Instead of comparing your results versus the theoretical S&P 500 return, using VOO returns are a much more realistic benchmark.

2. Failing to account for dividends

Another common mistake (or purposely misleading figure) some companies or people use is due to dividend accounting for the S&P 500. With a current yearly yield of about 2% to 3%, dividends add significantly to the overall total return.

However, some benchmark comparisons use the pure S&P index change, which excludes dividends, lowering returns and coincidentally making their performance look better. For comparison, 10-year returns for the S&P 500 with dividends results in a 162% increase while the same period without dividends yielded only a 110% increase.

A more accurate method is to compare with the VOO plus its yearly dividend yield or a total return measure including dividend reinvestment.

3. Forgetting taxes

Tax is another complicating factor in comparing returns, especially for special tax affected accounts. While the S&P 500 may gain 10% in one year, capital gains tax can change that figure significantly. Some people may end up with only a 15% capital gains tax, others are taxed at greater than 30%, and some may not be taxed at all. In some cases such as dividends from foreign-based stocks, an automatic 15% withholding is applied while for non-U.S. resident foreigners holding U.S. stocks, an automatic 30% is applied.

The mistake some people make is comparing real after-tax returns with S&P benchmark pretax returns. Even if you own a passive ETF and don’t sell, you likely still have an implied tax rate which Uncle Sam will make you pay someday. For more accuracy, compare equally on a taxed or non-taxed basis. I personally use pretax simply for convenience and ease of calculation though one should recognize the big potential for taxes to alter your final real return.

4. Missing the smaller picture

Stepping back from talking about the S&P 500 returns brings up the question of why we use the S&P in the first place. The S&P 500 is a list of 500 U.S. domiciled companies chosen by S&P Dow Jones Indices. While it is a good selected list of the largest and most important companies in the U.S. and covers about 80% of the total U.S. equity market by capitalization, there’s no inherent essentialness to it.

If the point of a benchmark is to compare versus the market, a more complete equity comparison would instead be the Wilshire 5000 or the tradable equivalent , the Vanguard Total Stock Market ETF VTI, +0.46%   which “represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and microcap stocks regularly traded on the New York Stock Exchange and Nasdaq.” While it still excludes certain investments such as ADRs and MLPs and non-U.S. headquartered companies, it’s a much more complete measure.

5. Looking only at the U.S.

Similarly, VTI also brings up the question of why we focus on U.S. equity markets as the standard benchmark. All practical modern equity asset allocations include a mix of both U.S. and international stocks. While U.S. companies are still among the largest and most important companies in the world, the U.S. market only makes up approximately one-third of the total world market cap ($18 trillion vs. $53 trillion, as per the World Bank), and thus captures only a small portion of the real “market” performance.

For a pure passive market comparison, the world index is arguably a more realistic measure. Though considerably smaller than their U.S. equivalents, the iShares MSCI ACWI Index ETF ACWI, +0.43%   and Vanguard Total World Stock ETF VT, +0.22%   both are reasonable alternative benchmarks to use.

6. Failing to recognize portfolio diversity

Lastly, the biggest mistake people make is using equity market indices like the S&P 500 as a benchmark for their total portfolios. While the S&P 500 or similar indices are reasonable benchmarks for equity based assets such as stocks or stock mutual funds, the average investor should have a balanced mix of bonds, REITs, or other non-stock assets. Those assets have a different mix of expected returns and volatility and serve different purposes.

Just as you wouldn’t compare a bond fund return to the S&P 500, you shouldn’t compare your total diversified portfolio to the S&P 500. The best approach is to compare each asset type to its own benchmark or change to benchmarks that take these factors into account such as Sharpe ratios. However, for those who prefer something quicker and simpler, an alternative suggestion may be to compare vs. a simple 50:50 portfolio of the world market ETF and a bond market ETF AGG, -0.05%  .

Though benchmark comparisons are an important part of investing discipline and useful for identifying both successes and failures for possible portfolio changes, it is only true if they are apple-to-apple comparisons. I find this especially relevant when people contact me lamenting their portfolio underperformance vs. the S&P 500 — a properly diversified portfolio has different risk-reward profiles and thus should not be simply compared with the S&P 500.

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